Managing risk is a key component of successful investing. There is investment risk that we try to mitigate through diversification. We invest to grow money so that we don’t lose our buying-power to inflation-risk. However, when designing a portfolio, we often hear the term “risk” used interchangeably with volatility.
Volatility poses a couple of different risks to our investing success that we will examine in the next two posts. Understanding this will help us to navigate some of the dilemmas that we face while planning an investment portfolio to meet our own goals.
What is volatility?
We usually hear about volatility when the markets drop. However, volatility really refers to the magnitude of price swings in both directions – up or down. The reason that volatility and price decline are often used interchangeably is that the market is most commonly moving slowly up (>70% of the time) punctuated by intermittent rapid price drops. So, a rapid volatile move is usually in a downward direction. Larger downward moves even get arbitrary labels like pull-backs (5%), corrections (10%), or bear markets (>20%). Makes for exciting financial speak.
Why Volatility Matters: The Journey & The Destination
If the labels are arbitrary, and the overall direction is up, why should we care about volatility? The answer lies in both the journey (behavioral risk) and the destination (sequence of returns risk). One is human and the other is mathematical.
Behavioral Risk: The Journey
If we entered the market in 1950 and just rode it out until 2018 in the above chart, then we are winners. The difficulty in doing that is the plethora of potholes, exhilarating hills, and corners along the road to get there. These pose a behavioral risk. They poke our inner emotional investor in the eye.
We are emotionally wired to “buy high” and “sell low” due to greed and fear. The opposite of optimal investing. If we allow our inner emotional investor beast to gain control, we may wake up with nothing but a smashed portfolio and ripped purple jean-shorts.
The Behavioral Performance Gap
Bad investing behavior is hard for us humans to overcome. It is driven by the powerful primitive emotions of fear and greed that have been hardwired into our psyche. Because we invest like humans, there is a gap between what investments return and what investors actually achieve called the behavioral gap.
The behavioral gap can amount to a ~0.2%-2% annualized drag on returns depending on the time period looked at and the volatility in that period. A more volatile period or a more volatile asset mix was associated with a larger performance gap. More volatility = more emotional mistakes = worse performance. Here is some data from the past decade.
It’s funny. When I googled “sinkhole swallows car”, there were images from pretty much every major Canadian city. This one was local. Like corrections and bear markets – potholes and even large sinkholes are common.
Emotions can easily trump logic in a pothole.
Logically, we all know that the driver and car will eventually be successfully extracted from this hole. However, tell that to the driver inside. Investing is the same way. People can pontificate about their nerves of steel and investment discipline, but the view is different from the inside of the 40% pothole of a bad bear market.
It is not just about the depth of a market decline.
A bad bear market can also last years. It is like being told, “Don’t worry the tow truck is coming. We just don’t know when. Or how close you are to the nearest town”.
A pervasive bear market and recession will also permeate the media and lives of those around you. Like a crowd gathering around the pothole screaming hysterically or commenting about how bad it looks. It is really difficult to ignore or rationalize emotions for that length of time in that type of environment. It is why I think that investing intestinal fortitude testing (desktop or mobile) should be part of assessing risk tolerance.
Don’t get lost in a pothole (“The Big Mistake”).
“The Big Mistake”, driven by fear, is selling at the bottom of a bear market when it feels like financial armageddon. The behavioral gap from this mistake would be way more than 2%! If I had sworn off of investing in 2007/8, it would now be a few hundred percent.
Rationally, we know that markets should recover long-term and that if they don’t – money won’t matter anyway. It will be about ammo, toilette paper, and a good squirrel stew recipe. Regardless, many people irrationally bail during drawdowns and miss the ride back up.
Emotionally driven behavioral mistakes aren’t just from downward volatility. A brisk ride up a hill and the exhilaration of an airborne investment is equally dangerous. It may seem obvious in a car, but is more subtle in investing.
Fear of Loss. Powerful.
Fear can also cause us to sell when our investments have been rising. We fear the loss of those investment gains. Loss aversion is extremely powerful and some estimate that it is twice as powerful as the prospect of gain in influencing how we act. Like all emotions, it can make us behave irrationally.
Fear of missing out or greed can also damage investor performance.
There is a powerful evolutionary drive to want what others desire and follow the herd. This behavioral mistake is characterized by piling into an investment that has recently shot up in price. It is usually followed by a subsequent drop to a more rational price when the mania settles.
This drags down investor performance due to the poor timing of “buying high”. It can also really heighten risk if our enthusiasm causes us to overweight ourselves in the overpriced asset. The opposite of diversification. Seeing an investment grow makes us feel good – our investor beast wants more of that. In extreme cases, leverage can heighten that risk even further. Our investing becomes gambling.
Our financial journey isn’t a straight line or a predictable course. Life is full of unexpected curves along the way. If we have good risk capacity (the ability to absorb unexpected losses or financial shocks), then these curves are less provocative to our emotions.
Volatility & The Destination
When we need the money that is invested, then volatility poses another risk. If the market happens to be in one of its potholes when we need to withdraw cash, there may not be enough there. This is why money that we will need in the next few years should not be invested. It should be saved. We invest our capital now to use it in the more distant future.
As we approach the destination where we start to use our financial capital, the behavioral risk does not go away. It may be heightened since we may have less human capital left to build more financial capital. The stakes are higher when we can’t simply work more. Spending less is also an option, but that sucks too. My aging body needs luxury.
As we approach or are newly arrived at the destination (like retirement), the mathematical risk of volatility also heightens. Hopefully, you will see this coming and plan accordingly. More on that in Volatility & Risk Part 2: Sequence of Returns Risk.